Return Predictability and the Implied Intertemporal Hedging Demands for Stocks and Bonds: International Evidence

We investigate return predictability and the implied intertemporal hedging demands for stocks and bonds in the U.S., Australia, Canada, France, Germany, Italy, and U.K. We first estimate predictive regression models for domestic bill, stock, and bond returns in each country, where returns depend on the nominal bill yield, dividend yield, and term spread. Employing the recently developed methodology of Campbell, Chan, and Viceira (2003), we calculate the implied optimal asset demands, including their myopic and intertemporal hedging components, for domestic bills, stocks, and bonds for an investor with an infinite horizon and Epstein-Zin-Weil utility in each country. We find that return predictability generates sizable positive intertemporal hedging demands for domestic stocks in the U.S. and U.K., while the intertemporal hedging demands for domestic stocks are decidedly smaller in Australia, Canada, and Germany and essentially zero in France and Italy. The intertemporal hedging demands for domestic bonds are negative and reasonably large in magnitude in the U.S., France, Germany, and Italy, while they are considerably smaller in magnitude in Australia, Canada, and the U.K. We also calculate optimal asset demands for an investor in the U.S. who, in addition to domestic bills, stocks, and bonds, has access to foreign stocks and bonds. We continue to find a sizable positive intertemporal hedging demand for U.S. stocks, and an important positive intertemporal hedging demand for U.K. stocks emerges. In another exercise, we find that investors in Australia, Canada, France, Germany, Italy, and the U.K. who have access to U.S. stocks and bonds all display sizable positive intertemporal hedging demands for U.S. stocks. Overall, we discover interesting similarities and differences in the implied intertemporal hedging demands for stocks and bonds across countries, and our results indicate that return predictability implies especially strong intertemporal hedging demands for U.S. and U.K. stocks

Trends and Persistence in Primary Commodity Prices

This paper applies new time-series procedures to examine the Prebisch-Singer hypothesis of a secular deterioration in relative primary commodity prices and the nature of their persistence. Employing a dataset of 24 relative commodity prices for the 1900-98 period, the pervasiveness of the Prebisch-Singer hypothesis is shown to be a function of a priori selected decision criteria, providing an explanation of conflicting findings in the recent literature. Moreover, much less persistence is found in the relative commodity prices than previously reported, since 23 out of the 24 commodities can be classified as trend-stationary. This implies there may well be more room for stabilization and price support mechanisms than previously advocated.primary commodities, unit root tests, structural breaks

Low frequency movements in stock prices: a state space decomposition

Previous analyses have concluded that expectations of future excess stock returns rather than future real dividend growth or real interest rates are responsible for most of the volatility in stock prices. In this paper, we employ a state-space model to model the dynamics of the log price-dividend ratio along with long-term and short term interest rates, real dividend growth, and inflation. The advantage of the state space approach is that we can parsimoniously model the low frequency movements present in the data. We find that if one allows permanent changes, even though very small, in real dividend growth, real interest rates, inflation but not excess stock returns then expectations of real dividend growth and real interest rates become significant contributors to fluctuations in stock prices. However, we also show that stock price decompositions are very sensitive to assumptions about which unobserved market fundamentals have a permanent component. When we allow excess stock returns to have a permanent component but not real dividend growth, then excess stock returns becomes an important contributor to stock price movements while real dividend growth is not. Unfortunately, the data is not particularly informative about which of these alternative models is more likely.Dividends ; Stock market ; Stocks ; Inflation (Finance)

Can the term spread predict output growth and recessions? a survey of the literature

This article surveys recent research on the usefulness of the term spread (i.e., the difference between the yields on long-term and short-term Treasury securities) for predicting changes in economic activity. Most studies use linear regression techniques to forecast changes in output or dichotomous choice models to forecast recessions. Others use time-varying parameter models, such as Markov-switching models and smooth transition models, to account for structural changes or other nonlinearities. Many studies find that the term spread predicts output growth and recessions up to one year in advance, but several also find its usefulness varies across countries and over time. In particular, many studies find that the ability of the term spread to forecast output growth has diminished in recent years, although it remains a reliable predictor of recessions.Economic forecasting ; Recessions

Nonlinear dynamics and covered interest rate parity

Interest rates

Explaining stock price movements: is there a case for fundamentals?

Some observers have argued that the run-up in the Standard & Poor's 500 stock price index during the 1990s was due to irrational exuberance rather than market fundamentals. This article presents evidence that the case for market fundamentals is stronger than it appears on the surface. Nathan Balke and Mark Wohar show that movements in the price-dividend and price-earnings rations have exhibited substantial persistence, particularly since World War II. Hence, using the long-run historical average value of the price/earnings or price/dividend ratio as the "normal" valuation ratio is misleading. The authors also show that plausible combinations of lower expected future real discount rates and higher expected real dividend (earnings) growth could rationalize current broad market stock values, raising the possibility that changes in market fundamentals have made a major contribution to the run-up in stock prices. Even if market fundamentals were responsible for the increase in stock prices during the 1990s, we should not necessarily expect future stock returns to be as high as the returns seen in the latter half of the 1990s.Stock - Prices ; Stock market

Forecasting US inflation using dynamic general-to-specific model selection

We forecast US inflation using a standard set of macroeconomic predictors and a dynamic model selection and averaging methodology that allows the forecasting model to change over time. Pseudo out-of-sample forecasts are generated from models identified from a multipath general-to-specific algorithm that is applied dynamically using rolling regressions. Our results indicate that the inflation forecasts that we obtain employing a short rolling window substantially outperform those from a well-established univariate benchmark, and contrary to previous evidence, are considerably robust to alternative forecast periods

Breaking Trends and the Prebisch-Singer Hypothesis: A Further Investigation

This paper examines the Prebisch-Singer Hypothesis employing new time se- ries procedures that are robust to the nature of persistence in the commodity price shocks, thereby obviating the need for unit root pretesting. Speci…cally, the proce- dures allow consistent estimation of the number of structural breaks in the trend function as well as facilitate the distinction between trend breaks and pure level shifts. In comparison with past studies, we …nd fewer cases of commodities that display negative trends thereby weakening the case for the Prebisch-Singer Hypoth- esis. Finally, a new set of powerful unit root tests allowing for structural breaks under both the null and alternative hypotheses is applied to determine whether the underlying commodity price series can be characterized as di¤erence or trend sta- tionary processes. Relative to the extant literature, we …nd more evidence in favor of trend stationarity suggesting that real commodity price shocks are mostly of a transitory nature.primary commodity prices, structural breaks, trend functions, Prebisch- Singer Hypothesis, unit roots, Demand and Price Analysis, Marketing, Research Methods/ Statistical Methods, 013, C22,

Long Memory Regressors and Predictive Regressions: A two-stage rebalancing approach

Predictability tests with long memory regressors may entail both size distortion and incompatibility between the orders of integration of the dependent and independent variables. Addressing both problems simultaneously, this paper proposes a two-step procedure that rebalances the predictive regression by fractionally differencing the predictor based on a first-stage estimation of the memory parameter. Extensive simulations indicate that our procedure has good size, is robust to estimation error in the first stage, and can yield improved power over cases in which an integer order is assumed for the regressor. We also extend our approach beyond the standard predictive regression context to cases in which the dependent variable is also fractionally integrated, but not cointegrated with the regressor. We use our procedure to provide a valid test of forward rate unbiasedness that allows for a long memory forward premium

Can Return Forecasts enhance International Asset Allocation? Evidence from the Sum-of-Parts Approach

We examine whether real-time return forecasts are valuable to an investor looking to allocate their portfolio across a wide selection of countries. We expand the Sum-of-Parts (SoP) method for forecasting stock returns to an international setup by adding FX returns as an additional component. We use two different methods to calculate the forecasts. The first method (Empirical Mode Decomposition) uses wavelets to frequency decompose each part into locally independent sub-signals, while the second method combines historical averages and predictive regressions. We then compare the performance of various types of portfolia under the SoP and historical average forecasts, with rebalancing taking place every period. We find that SoP forecasts deliver economic gains over the historical average, especially when the EMD method is implemented. We further demonstrate that economic gains can be generated for investors based in various different countries